Market outlook October: The stock market is resilient to interest rate increases.
The rise in government bond yields in the USA continued with renewed strength in September, contributing to weak returns in most interest segments. In the stock market, returns were also on the weak side, but it does not seem that investors there are very worried about higher interest rates. This is due, as we see it, to the fact that the rise in interest rates is primarily driven by strong growth.
Overall, we are comfortable having a neutral allocation between equities and bonds. In a climate marked by uncertainty related to rising interest rates and geopolitical turmoil, but still strong earnings growth related to AI, we believe we are well positioned, with overweight in Nordic high yield and Norwegian bonds in the fixed income portfolios, and in technology, finance, and healthcare stocks in the equity portfolios.
Renewed interest rate anxiety in September, but growth remains the main driver
The development in the stock market was on the weak side in September, with a decline in global stocks of about 1% measured in local currency.
However, it was in the bond market that the largest movements occurred in September, with interest rates on government bonds in the US, both short and long term, rising sharply in the latter half of the month. As we have written in more detail here, we believe that the main driver behind the rise in interest rates so far this year is strong growth and high demand pressure in the US economy. This explains why the stock market has generally taken the rise in interest rates in stride.
That said, we are seeing signs that the stock market is reacting more negatively to rising interest rates when they are sharp, meaning large movements in a short time. The last week of September, we had several days with relatively large movements in the important 10-year rate, and this seems to have created more turbulence in both the stock market and other risky assets. The stock market fell moderately on these days, and credit spreads in the high yield market in the US have increased in the past week.
The fact that oil prices are rising at the same time as interest rates increases also contributes to negative outcomes in risky assets, both because higher oil prices in themselves are negative for the real economy, and because it creates uncertainty about what is driving the interest rate increase. An interest rate rise driven by higher oil prices is more negative for stocks than an interest rate rise driven by strong demand. As mentioned, we are inclined to believe that the latter driver is the most important, but concerns related to the situation in Iran and its effect on commodity prices also contribute to raising interest rate expectations, and thus long market rates.
Whether further interest rate increases will be negative for the stock market depends, as we see it, on two factors: 1) that it continues to be driven primarily by higher growth expectations, not concerns related to oil prices, and 2) that the movements in market rates remain relatively moderate, and that jumps of 10-15 basis points in a day, as we have seen a couple of days last week, do not happen frequently.
We believe in both, and are therefore not very concerned about the development in the stock market, even in a situation where market rates could rise somewhat more from current levels. A robust US economy, which is less sensitive to higher rates, and stocks supported by strong earnings growth, can likely withstand an interest rate level between 5% and 6%..
A greater concern remains that the rise in the stock market is resting so heavily on sky-high earnings estimates that are largely tied to one theme, namely AI. Roughly estimated, technology companies have contributed to 2/3 of the increase in earnings estimates so far this year. Companies in the industrial and materials sectors have also contributed significantly, and much of this can also be attributed to earnings related to the development of AI infrastructure (data centers). The massive sums being invested in the development of AI infrastructure are thus what largely sustains the stock market’s rise, and there is still significant uncertainty about how profitable these investments will be, and how long the rate of investment can continue at this strength.
Overall, we are comfortable having a neutral allocation between stocks and bonds in our funds and portfolios now. This is both because the stock market is characterized by a lot of uncertainty related to everything from interest rates and energy prices to AI earnings, and because the ongoing return from bonds improves the higher market rates go.